why does a developing economy that moves from being segmented to being integrated result in increase in equity prices in the economy. i don’t follow this explanation: the variance of the segmented market is more than the covariance of the integrated market, hence integration leads to low risk and higher equity prices.
'nyone?
'nyone? v.02
When an economy moves from being segmented to being integrated (or is liberalized), there is more capital inflows into the economy, thus making capital cheap and reducing the cost of capital, this leads to higher equity prices. This is how I have understood it, the statement mentioned by you might be a statistical explanation for this effect.
I hate the Schweser explanation, but trying to work with it… if a stock is in a segregated market, we don’t evaluate it based on beta with the overall global market, but rather on a standalone basis looking at standard deviation (or variance). Remember the financial market equilibrium model, where we solve for the equity risk premium, and we drop the correlation benefit for a stock in segregated markets? So after the market is integrated, we start to evaluate it based on its beta, or covariance with the global market, and the correlation/diversification benefit helps lower the risk, boosting the equity price higher. does that sound even partially correct?
you have to look at it from a portfolio perspective. 1.the market is integrated - the ‘Price’ of the market is based on it’s risk and return, without taking into account any low correlation to other international assets, since the international investors won’t be able to invest 2. when the market becomes integrated, you have all the international investors. For them the risk of adding the emerging market to their portfolio is much less than the variance of the market because of low correlation benefits to their other assets. Therefore for them it is justified a much higher price for the Risk/Return Ratio they are getting
ilvino was faster than me. to that you can add that indeed decreased cost of capital should increase profitability of emerging markets companies
Not 100% sure here but to add to what gauravku is saying most of the time it seems like the lower the stock price the higher the risk premium. So a higher price, means less risk premium and less uncertainty, which comes from integration. Vice versa as well. Does that help?
good point, florin - the lower cost of capital should reduce the required rate of return on a stock, so using GGM you can justify a higher price.
makes a lot of sense now … thanks guys